What happens to their shares when there is a sudden death of a founder?  

When a group of people set up a business, pretty much all the focus tends to be on making the business successful. Quite rightly, this focus is important. However, not much attention is given to what happens if there is a death of a founder.

What might be a low priority for the founders is succession planning. This is especially true for planning for the death of a founder. Although people tend not to want to think about the death of a founding shareholder, it can lead to very material consequences. These consequences affect not just the business itself, but also the founder’s family members, investors, other shareholders, and employees.

This article will focus on the importance of having a provision in a shareholders’ agreement on what happens to shares when a founder dies. 

What happens to a founder’s shares on death? 

The starting point, by law, is that on a founder’s death, the founder’s shares pass under the term of his/her will. If there is one, shares are passed under the will. Alternatively, under the intestacy rules, the shares pass in absence of a will. If there’s nothing else other than the agreement entered into by the founder, the shares pass to the beneficiary named in the will. The beneficiary could be either a family member or a non-relative.

If a founder dies without a will and assuming the founder has not previously agreed anything else, the founder’s immediate family will inherit the shares. This includes his/her spouse or children. However, the company’s articles of association or any applicable shareholders’ agreement can override this ‘starting point’.

Why is it important to include specific provision relating to transfer of shares on death?

Under a shareholders’ agreement, the founders are free to negotiate the terms of the agreement. This includes whether to include a provision relating to the transfer of shares when a founder dies. The reason we recommend this provision is important. Without it, the beneficiary, who may not know the business, would have rights to participate in shareholder decisions. These decisions may impact the business operation. As such, there is a likelihood that the remaining shareholders’ interests may not align with the decisions made by the new shareholder. This could lead to tension between the beneficiary and the remaining founders.

Another problem that could arise is that the new shareholder may not understand their duties. Sometimes, they may fail to engage with the decision-making process of the company. This means the company may not obtain the required approval to make key shareholder decisions.

What happens if the founder was the sole director?

A private company must have at least one director. Therefore, the death of a founder who was the sole director can have a materially detrimental impact. If the deceased founder was a sole director of the company, the surviving shareholders would need to make sure a new director is appointed. 

If the company’s shareholders’ agreement allows the personal representatives (PRs) to appoint a new director, the PRs will have the power to do so. However, if this power is restricted, the process of appointing a new director can be complicated. There may be a need to amend the terms of the existing shareholders’ agreement for the PRs to exercise this power.

Also, in terms of practicalities, it can take a very long time for the will of the deceased founder to be properly administered. Matters can take a while to be finally resolved.

How can the situation be mitigated? 

As mentioned above, a shareholders’ agreement (being a contract between founders) can override the ‘starting point’ position. So founders can think, up front, about what they want to happen on death.

For example, it could be as simple as allowing surviving shareholders the first opportunity to purchase the deceased’s shares. Alternatively, it could be about giving the remaining founders the right to appoint a director if the deceased founder was a sole director. Or one could provide that the shares remain with the beneficiary of the deceased. This way, they can continue to benefit from all, or potentially different, amounts of dividends and capital receipts but have no voting rights.

Alternatively, a company could enter into a cross-option agreement with all founders. The effect of this agreement is significant. It would provide an opportunity for the surviving founders to buy back the deceased founder’s shares at market value. Additionally, it requires the PRs to sell the deceased’s shares under the terms of the cross-option agreement.

With a cross-option agreement, each founder is required to take out a life insurance policy on his/her life. However, the benefit of the policy is held in trust for the surviving founders. The purchase of the deceased’s shares is then funded from the life insurance policy proceeds. This ensures the exercise of the cross-option is a low-cost exercise for the remaining shareholders.

Although succession planning may not be your priority, it is important to be aware of the consequences of not having a plan for unexpected events. If you require any assistance with putting a shareholders’ agreement in place, our team at Farringford Legal can help.